German Court Rules Against Deutsche Bank

Published: March 23, 2011

3:29 p.m. | Updated

FRANKFURT - In a potentially far-reaching decision, Germany's highest appeals court ruled on Tuesday that Deutsche Bank must compensate a small-business customer for losses incurred as a result of an interest-rate swap.

The decision could raise the liability of German banks for the complicated financial products they sell and affect other banks doing business in the country.

Representatives of plaintiffs in similar suits immediately praised the decision by the Federal Court of Justice in Karlsruhe.

''We are overjoyed,'' said Andrea Hermesmeier, general counsel for the city of Pforzheim in southern Germany, which is suing JPMorgan Chase in a Frankfurt court for some 57 million euros in losses from a swap transaction. ''It certainly sets a precedent,'' she said.

While the direct legal ramifications are limited to Germany, the Deutsche Bank case focuses attention on billions of dollars of exotic financial products that banks sold to customers in many countries, including the United States, who later experienced severe losses.

Swaps were often marketed as ways for businesses or communities to minimize interest payments, but the bank customers either underestimated or were not fully informed about the huge sums they could lose if financial markets went in the wrong direction.

The Federal Court of Justice concluded that Deutsche Bank had failed to adequately warn its customer, a supplier of paper products, about the risks of the transaction, known as a CMS Spread Ladder Swap. In addition, the swap was rigged against the customer so that Deutsche Bank would be able to resell its side of the transaction to other investors, the court said.

The bank ''deliberately designed the risk structure of the transaction to the disadvantage of the client, in order to immediately resell the risk at a profit,'' the court said in a summary of the decision, which reversed a ruling by a lower court.

The decision against Deutsche Bank, which found that the bank had a ''grave conflict of interest,'' was reminiscent of accusations last year that Goldman Sachs fraudulently sold a mortgage security to customers just as cracks appeared in the housing market. That security, called Abacus 2007-AC1, allowed a prominent hedge fund manager, John A. Paulson, to place a bet against mortgage bonds.

One of the customers in the Goldman case was IKB Deutsche Industriebank, a German bank that required a taxpayer bailout. Goldman settled a civil complaint filed by the Securities and Exchange Commission in the Abacus case last year for $550 million.

Similar cases around the world, involving local governments like Jefferson County, Ala., or the city of Milan, have prompted courts and lawmakers to crack down on the way banks market swap transactions.

''This market was the wild west,'' said Peter Shapiro, managing director of the Swap Financial Group in South Orange, N.J., which advises communities, companies and other swap customers. ''It was not regulated, it was a buyer-beware market.''

''It's going from wild west to heavily policed,'' Mr. Shapiro said, noting that Congress last year imposed regulations on the way banks sell swap products.

The suit decided Tuesday was one of 25 similar cases pending against Deutsche Bank, said a bank spokesman, Ronald Weichert, including eight at the Federal Court of Justice. The bank's maximum exposure from the suits would be substantially less than 100 million euros, he said.

''We will carefully review the written reasons for the judgment,'' Deutsche Bank said in a statement. ''Only then will it be possible to determine whether and to what extent this affects other financial transactions.''

The bank does not plan to appeal in this case, Mr. Weichert said.

But Michael Schick of Rossner Rechtsanwalte, a Munich law firm that represented the Deutsche Bank customer, said that the decision set a high standard for the information that banks should have supplied to customers and could open the door to hundreds of complaints against Deutsche Bank and other institutions.

Virtually all of Germany's commercial banks, as well as some government-owned Landesbanks, sold swap products, whose total value was estimated at about 1 billion euros, he said.

''This is a fundamental decision,'' Mr. Schick said. ''There will be more complaints coming.''

The Deutsche Bank customer, Ille Papier Service, which supplies products like paper-towel dispensers to businesses, put its losses from the transaction at 541,000 euros ($769,000). The swaps had a negative market value of 80,000 euros on the day of the transaction, the court said, a fact that Deutsche Bank did not disclose to the customer.

''We never thought we could win this 'David vs. Goliath' battle,'' Wilhelm Blatz, founder of Ille Papier, said in a statement. The company is based in the town of Altenstadt, about 20 miles from Frankfurt.

Marion Gottschalk, managing partner at Ille Papier and the daughter of Mr. Blatz, said the company bought the swaps in 2005 after declining to purchase them from a Deutsche Bank representative on several previous occasions.

The bank told the company that the swaps were a way to pay less interest than it had up until then, Ms. Gottschalk said.

Ms. Gottschalk said her father told the bank representative he did not understand the product, but would buy it on trust, since he had been advised by Deutsche Bank for 10 years.

A spokesman for the Association of German Banks, Volker Knauer, said the group would not be able to judge the wider impact of the case until the court issues a full written decision, which is not expected for several weeks.

Ms. Hermesmeier, the lawyer for the city of Pforzheim, said that while there were differences among the cases, the court's assessment of a bank's responsibility to inform clients seemed to apply widely. A spokesman for JPMorgan in Frankfurt, Axel Ludeke, said he could not comment on the legal complaint suit against the bank by the city.

Pforzheim had previously suffered losses from a swap transaction with Deutsche Bank, and is in settlement talks, Ms. Hermesmeier said. Even without the swaps losses Pforzheim has been struggling because its jewelry industry, once world famous, has largely migrated to Asia and undercut the tax base, she said.

''It will add to the structural problems we already had,'' Ms. Hermesmeier said. ''We have no reserves anymore. We have to start thinking about cuts in services.''